The Evolution of Consolidated Financial Reporting in Australia

An Evaluation of Alternative Hypotheses

Greg Whittred

• Publisher: Routledge
• Year: 2020
• Print ISBN: 9780367496975
• eBook ISBN: 9781000166910
• Topic: Business
• Subtopic: Accounting
• Index: Business

This book, first published in 1988, aims to provide evidence on the voluntary adoption of a particular type of financial statement – the consolidated financial statement – in what may be characterized as relatively high agency cost situations. This study examines an accounting method choice not under the assumption that it will be made opportunistically but under the assumption that it will be negotiated ex ante as part of the firm's optimal contract structure.

Chapter 1

Introduction

In their attempt to develop a theory of the ownership structure of firms Jensen and Meckling (1976) define the concept of agency costs, investigate the nature of the agency costs generated by the existence of debt and outside equity and demonstrate who bears these costs and why. In the process the central role of monitoring and bonding activities in reducing agency costs becomes apparent. In this respect, Jensen and Meckling (p. 338) provide an example of the way in which audited financial statements might reduce agency costs:

Suppose, for example, that the bond holders (or outside equity holders) would find it worthwhile to produce detailed financial statements such as those contained in the usual published accounting reports as a means of monitoring the manager. If the manager himself can produce such information at lower costs than they (perhaps because he is already collecting much of the data they desire for his own internal decision making purposes), it would pay him to agree in advance to incur the cost of providing such reports and to have their accuracy testified to by an independent outside auditor.

Watts (1977) pursues the theme that the function of audited financial statements is to reduce agency costs and provides a number of hypotheses which illustrate the manner in which the agency framework might be employed to explain both the existence of financial statements and cross-sectional variation in the content thereof.

Jensen and Meckling imply and Watts hypothesises that audited financial statements are likely to be part of any contracting equilibrium in which agency costs are potentially high. However, neither Jensen and Meckling nor Watts confront their hypothesis with evidence on other than a casual basis. While doing so was beyond the scope of their analyses the result has been a lack of evidence on what is an Important maintained hypothesis in much of the subsequent “positive” research in accounting – particularly that relating to accounting method choice.¹

This study to provides evidence on the voluntary adoption of a particular type of financial statement – the consolidated financial statement – in what may be characterized as relatively high agency cost situations. Further, and in contrast to prior studies which, with one exception,² investigate management’s policy choices taking existing contracts (and the accounting choices available under them) as given; this study examines an accounting method choice not under the assumption that it will be made opportunistically but under the assumption that it will be negotiated ex ante as part of the firm’s optimal contract structure.

1.1   Organisation of the Study

Chapter 2 reviews the development of consolidated financial reporting in Australia, and in particular. New South Wales (N.S.W.) and Victoria. Since financial reporting in Australia has been governed by rules developed from a variety of sources for quite some time considerable effort is expended in identifying a sample(s) of companies that may be described as consolidating in the absence of any specific institutional requirements to do so. As a by-product of this effort empirical evidence on (a) the reporting practices of Australian companies over the period 1930–1962 and (b) the extent of compliance with various institutional reporting requirements is, for the first time, made available.

 

1.     This is not to suggest that empirical evidence is entirely lacking. Recent papers by Leftwich, Watts and Zimmerman (1981) and Chow (1982) consider the derived demand for interim reports and auditors respectively (both monitoring devices), as a function of agency costs. The latter provides evidence consistent with this view. Leftwich (1983) and Whittred and Zirnner (1985) provide evidence regarding the degree of dependence of, respectively, private and public debt contracts on the information contained in financial statements.

2.     Refer Zimmer (1986) and Chapter 4 infra.

Chapter 3 traces briefly the evolution of Australian capital markets and, in particular, the market for debt. The discussion here demonstrates that the rapid spread of the consolidated form of financial reporting coincided with the freeing up of the market for equity capital and the development of a market for public debt. This chapter also provides the rationale for a three way partitioning of the 1930–1962 time period which is employed in the empirical analysis.

Chapter 4 examines the determinants of management’s decision to consolidate. The nature of the contracting problems confronting management and the suppliers of both debt and equity capital are considered. In both cases the solutions likely to be negotiated (ex ante) to these contracting problems imply consolidated financial reporting will be part of the equilibrium outcome. The alternative hypothesis that consolidation is a manisfestation of ex post opportunistic behaviour by management is also considered.

Chapter 5 discusses the research design and related considerations, including data collection procedures. A conventional non-equivalent control group design is employed to analyse the data. A case study approach is also used to supplement the analysis. Chapter 6 provides a profile analysis of the resulting samples and the results of the hypothesis tests. The analysis is conducted over varying time periods. The data is initially partitioned into pre- and post- disclosure regulation samples (though all the latter companies were technically exempt from the requirement to consolidate). Based on a 1941 cut-off this provides samples of 10 and 70 companies respectively. The post-disclosure regulation sample is subsequently partitioned into two periods 1941–1951 and 1952–1962. This split is based on the fact that institutional changes in 1950–51 (the effective removal of Capital Issues Controls and changes in the tax system) imply non-stationarities in some of the independent variables.

Chapter 7 is devoted to a consideration of a number of alternative hypotheses for the phenomenon under consideration. Hypotheses are developed pertaining to the possibility that the practices of particular auditing firms or overseas influences may be responsible for management’s decision to consolidate. Taxation related incentives to consolidate may also exist and much of this chapter is devoted to a detailed consideration of this issue. As a result of this analysis evidence is presented (again for the first time) on the evolution of the holding company form in Australia and the importance of tax considerations therein.

Chapter 8 contains a summary and the principal conclusions reached. The research reported herein suggests that consolidation was more likely to be adopted in high agency cost situations i.e., those in which cross-guarantees between related corporations were present and/or in which management’s share of a firm’s equity was relatively small. The likelihood of consolidation was also a function of the number and type of subsidiaries. With the exception of the separation of ownership from control of the firm the relative significance of these factors was time dependent. The agency or contracting cost variables overwhelmed all others in terms of explanatory power, though it is apparent they were not the sole determinant of the consolidation decision.

Chapter 2

The Develoepment of Consolidated Financial Reporting in Australia

Corporate financial reporting in Australia has, for at least the last 60 years, been subject to rules developed from various sources. In this respect the provisions of the various Companies Acts, the listing requirements of the Australian Associated Stock Exchanges and, more recently, the standards issued by the professional accounting bodies (the Australian Society of Accountants and the Institute of Chartered Accountants in Australia) have all assumed importance. For much of this time holding companies’ financial statements have been accompanied by consolidated financial statements. Yet, it is possible to identify time periods in Australian history when these institutional requirements did not exist and in which companies were consolidating.¹ The identification of such time periods and companies is the purpose of this chapter. However, before proceeding to this task the scope of the search is restricted by confining attention to the States of N.S.W. and Victoria. These States have always been the most heavily populated and their capitals, Sydney and Melbourne, became at a very early stage the financial and commercial centres of Australia. For this reason (and for more practical considerations pertaining to data availability) attention hereafter is focussed upon developments in each of these States.

1. It could also be argued (following Posner (1977)) that the institutional framework evolved in order to facilitate private contracting arrangements. Tests of this hypothesis are beyond the scope of this study.

The chapter is structured as follows. The evolution of the rules from each of the institutional sources referred to above is reviewed in section 2.1. This allows the identification of a set of sample parameters or selection criteria which are discussed in section 2.2. Finally, section 2.3 documents the evolution of the consolidation practices of Australian companies. This survey provides the initial data base from which sample members are ultimately drawn.

2.1 Institutional Requirements

2.1.1 Legislative Provisions

The practice of consolidated financial reporting in Australia lagged by some 10–20 years corresponding developments in the United Kingdom (U.K.) and by some 30–40 years American practice.² The first set of consolidated accounts issued by an Australian public company appeared no later than 1931.³ However, the legislative provisions of certain States and in particular the 1938 Victorian Companies Act anticipated British legislation in this area by a decade. A Companies Bill had been introduced into the Victorian parliament in 1935 and after a three year passage passed into law on December 7, 1938.⁴ While still requiring a balance sheet the Victorian Act departed from the practice of its predecessors of specifying a format in the schedules. For the first time (in either the U.K. or Australia) a detailed profit and loss statement was required (Sn. 125(1)(a)). Finally the Act required, again for the first time, either separate statements (in the prescribed detail) for each subsidiary or the inclusion with the parent company accounts of the consolidated statements of the parent and its subsidiaries (Sn. 125 (1) (b)).⁵

2. Nobel Industries (1922) is generally credited with being the first U.K. consolidation (e.g., Nobes and Parker, 1979, p.199; Kitchen, 1972, p.126/7). However, Edwards and Webb (1984, p.38) provide evidence of U.K. companies consolidating as early as 1910. Nevertheless, it remained the case that the publication of consolidated financial statements was the exception rather than the rule throughout the 1920’ s. (Edwards and Webb, 1984, p.32; Walker, 1978, Chapter 6). Mumford (1982) provides evidence of U.S. companies consolidating as early as 1890. The development of consolidated reporting in the U.K. is reviewed in Kitchen (1972) and Walker (1978); in the U.S.A. by Walker (1978) and Mumford (1982); and in Australia by Gibson (1971). The latter author also documents in considerable detail the evolution of the legislative and Stock Exchange reporting requirements in Australia.

3. This is some four years earlier than the date documented by Gibson (1971) – refer section 2.3 infra and footnote 14.

The 1938 Act was followed by Western Australia in 1943 and was revised in 1958; this revision being adopted in Tasmania in 1959. However, similar requirements did not appear in the legislative provisions of the remaining Australian States until the Uniform Companies Act, 1961. In fact the requirements in the remaining states were modelled on those of the U.K. Companies Act, 1929 which was the first Act to require the disclosure of certain aspects of holding company affairs. Companies covered by this act were obliged to separately disclose investments in subsidiaries, the amounts due to and from subsidiaries, and to provide a statement of how the profits of the subsidiaries were dealt with but not the amount of these profits. Identical provisions were written into the New South Wales Companies Act, 1936 (Sns. 105, 106) and as observed above, remained in force until the Uniform Companies Act, 1961.

4. Gibson (1971, Chapter 5) describes the passage of this Bill and its “radical” requirements as tumultuous.

5. The definition of subsidiary company contained in the Act was sufficiently broad to cover sub-subsidiaries. However, it did not require that the accounts of the subsidiaries be made up to the same date as those of the holding company or the separate disclosure of minority interests. Further, the Act permitte...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Original Title Page
• Original Copyright Page
• Table of Contents
• Acknowledgements
• List of Illustrations
• List of Tables
• 1 Introduction
• 2 Development of Consolidated Reporting in Australia
• 3 Development of Australian Capital Markets : 1930–1960
• 4 Hypothesis Development
• 5 Research Design Considerations
• 6 Results
• 7 Alternative Hypotheses
• 8 Synthesis and Conclusions